ILS investors fear inflation model-miss more than climate change: Gallagher Securities

Insurance-linked securities (ILS) investors are more concerned about the potential for risk models to be inaccurate on inflation than on climate change, according to Gallagher Securities.

Writing in the latest renewals report from reinsurance broker Gallagher Re, the capital markets and ILS team at Gallagher Securities highlight what they see as a particular investor concern at this time.

They believe investors are more concerned on the potential for catastrophe risk model-miss when it comes to inflation.

It is the potential for inflation to have introduced inaccuracy in modelling that is driving the ILS investor concerns, Gallagher Securities explains.

Of course, when it comes to inflation and how this is dealt with in risk models, to a large degree it is down to the users of the models to load their results with an inflation related factor, to try to account for it in the model output.

It’s been particularly difficult to estimate the effect of inflation on catastrophe losses and still is. Despite government issued inflation figures providing a benchmark for inflationary effects, when it comes to natural catastrophe and weather losses there are numerous factors to consider, that are inflationary in nature.

Everything related to recovery, reconstruction and rebuilding needs considering, so the effects of inflation on adjuster, materials and labour costs, as well as how any supply-chains involved are currently performing.

Since the COVID pandemic, this has all become far more challenging to estimate with any degree of accuracy and the individual inflationary inputs have been moving much faster than was experienced before.

Add in social inflationary effects and the influence of regulatory environments, which have proved particularly challenging to predict, and it’s perhaps no surprise that inflation-related risk model-miss, or inaccuracy, is seen as the key concern for ILS investors at this time.

Perhaps related, at least to the topic of ILS investor concerns over the potential for risk models to prove inaccurate, Gallagher Securities also highlights that certain perils and structures remain out of favour at this time.

On the structural side, aggregate and cascading structures are decidedly out of favour still, according to the broker-dealer.

While on the risk side, ILS investors continue to shy away from so-called secondary perils, Gallagher Securities explained.

This is also due to the potential for model-miss, we suspect, as these are far harder to model with accuracy and thus introduce uncertainty and volatility into the performance of ILS fund portfolios and instruments such as catastrophe bonds.

With many ILS contracts repriced on an annual basis, or within three years for catastrophe bonds, it allows models to be recalibrated for the current understanding of climate related risks.

But, when it comes to inflation, the loading of pricing to account for these effects can be particularly challenging and inflation can be both volatile or transitory, meaning there could be effects that amplify it within contract terms.

A lot of the repricing undertaken through recent weeks and at the January 2023 reinsurance renewals has been undertaken to attempt to cover loss costs and provide more stable returns to investors over the long-term horizon, so these concerns over inflation may reduce as long as managers and structures can evidence that the new pricing baselines set are better accounting for inflationary effects.